Wednesday, June 23, 2010
Today's FOMC statement made no contribution to the market's understanding of the economy or the future course of Fed policy. The Fed knows just about as much as the market about what's going on—the U.S. economy is probably still growing, but there is the risk that the Euro debt crisis could be contagious. From a longer term perspective, the Fed is managing policy by looking in the rearview mirror, trying to nurse a sick economy (sick because it is almost 10% below trend growth) back to health with cheap money. Fed policy remains about as easy as it has ever been, as this chart suggests.
Fed governors, with the exception of Kansas Fed President Hoenig, have no interest in the message being sent by strong commodity prices, soaring gold prices, and the generally weak level of the dollar—namely, that money is in abundant supply and there is almost no chance that Fed policy is posing any problems for the economy. If anything, ongoing monetary accommodation may be fueling unrest among investors who worry about how the Fed's addition of $1 trillion to bank reserves will be unwound and what problems that may create in the interim (e.g., rising inflation, asset price bubbles).
Investors also worry about fiscal policy, which has been incredibly "stimulative" according to the Keynesian framework. Very easy money plus very stimulative fiscal policy for the past 18 months and we only have a modest recovery that is at risk of a Greek debt default? Yikes, maybe the economy is hanging by a thread...
A better way to understand things is from a supply-side/monetarist/classical economic perspective. Easy money can't create growth, it can only create inflation. Deficit-fueled spending also can't create growth, especially when, as now, it consists mostly of transfer payments that simply redistribute wealth in a way that weakens incentives to work and invest. Huge deficits and huge new government spending programs (e.g., Obamacare) further weaken investor confidence since they hold the threat of a major increase in future tax burdens. A lack of investor confidence in the future stability and strength of the dollar and the future level of tax rates and tax burdens equates to uncertainty, and uncertainty is bad for investment. If investment is weak, then economic growth is hard to come by. It takes hard work and risk-taking to create new companies and new jobs.
So the more the Fed tries to pump up growth with low interest rates, and the more Congress tries to pump up growth with new spending schemes, the worse it is for the economy. There is a dreadful lack of understanding of the basic principles of economics in Washington, especially among the Obama administration and members of the Democratic Party.
I believe that the market has been worried for a long time about the course of fiscal and monetary policy. Investors and risk-takers understand how things work much better than most politicians do. There are abundant signs of just how concerned the market is, from zero interest rates on cash to 3% interest rates on 10-yr Treasury bonds, and from above-average credit spreads to historically high implied volatility and $1200 gold prices. Morever, equity valuations have severely lagged the growth in corporate profits.
In this view of the world, the market advance to date has largely occurred despite the bad news from Washington, the Fed, and the Greeks, and the economy is recovering despite all the headwinds, thanks to the inherent dynamism of the U.S. economy and a free people's innate desire to improve their lot in life by working harder and finding ways to do things more efficiently. It's not a huge recovery or even a typical recovery, given the depth of the recent recession, but it is a recovery and it is likely to continue.
The one bright spot on the horizon, and something that could make a huge difference to the economy and the markets, is the upcoming November elections. It is the hope—and the increasing likelihood—that these elections could yield a significant rightward shift in fiscal policy that is sustaining what little optimism can be found. I think it's hard to underestimate the importance of this, because all the signs on the margin point to a sea-change in the public's attitude toward fiscal and monetary policy. When and if this change translates into an improved policy outlook, we could see an explosion of optimism, and that would be a very good thing indeed.
Posted by Scott Grannis at 12:45 PM